Application Policy

NUMBER: SR&ED 2004-01
DATE: January 20, 2004
SUBJECT: Retiring Allowance

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Purpose

The purpose of this application policy is to clarify the position of the Canada Revenue Agency (CRA) in determining the allowable Scientific Research and Experimental Development (SR&ED) expenditures and the expenditures that qualify for investment tax credit (ITC) purposes where a claimant makes a payment to an employee or a former employee in respect of a retiring allowance. Unless otherwise stated, all statutory references throughout this paper are to the Income Tax Act (the "Act").

Background

A retiring allowance is an amount paid on or after the retirement of an employee in recognition of long service or in respect of the loss of an office or employment. A claimant may describe any amounts paid to an individual as a result of the loss of an office or employment as termination or severance pay. Therefore, for the purpose of this paper, the term "retiring allowance" includes a payment for the loss of an office or employment that is described as a termination or severance pay.

Depending upon the circumstances, it may be difficult to determine whether a payment to an employee is a retiring allowance or salary or wages. The current versions of the interpretation bulletins IT-196, Payments by Employer to Employee, and IT-337, Retiring Allowances, will provide assistance in making such a determination.

Generally, any amount payable under a written or oral agreement, which has the nature and quality of salary, wages, commissions, accrued vacation pay, etc. would be considered salary or wages. However, in some cases, it could be considered a retiring allowance.

Legislation and Interpretation

Subsection 248(1) defines a "retiring allowance" as an amount received by the taxpayer or, after the taxpayer's death, by a dependant or a relation of the taxpayer or by the legal representative of the taxpayer:

• on or after retirement of a taxpayer from an office or employment in recognition of the taxpayer's long service, or
• in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.

A retiring allowance includes an amount received in respect of a loss of an office or employment. In this context, the words "in respect of" have been held by the Courts to imply a connection between the loss of employment and the subsequent receipt, where the primary purpose of the receipt was compensation for the loss of employment.

Two questions set out by the Courts to determine whether a connection exists for purposes of a retiring allowance are as follows:

1. But for the loss of employment, would the amount have been received? and,
2. Was the purpose of the payment to compensate a loss of employment?

Only if the answer to the first question is "no" and the answer to the second question is "yes", will the amount received be considered a retiring allowance i.e. the amount would not have been received if there was no loss of employment and the payment was made to compensate for the loss of that employment.

A retiring allowance does not include:

• a superannuation or pension benefit (see the current version of IT-499, Superannuation or Pension Benefits);
• an amount received as a consequence of the death of an employee (see the current version of IT-508, Death Benefits); or
• a benefit from counselling services described in subparagraph
  6(1)(a)(iv);
• salary and/or wages;
• accrued vacation pay;
• an amount received out of or under an employee benefit plan or a salary deferral arrangement;
• a reimbursement of legal costs;
• a retention bonus for reporting to work until the termination date; and
• an amount received upon or after retirement where a low (or no) salary was received before retirement. Such an amount is more likely to be regarded as deferred compensation, taxable as income from office or employment when received rather than as a retiring allowance.

A retiring allowance is included in the income of the recipient under subparagraph 56(1)(a)(ii). However, it is not considered to be salary or wages as defined in subsection 248(1). As a result, a retiring allowance cannot be allowed as salary or wages under either the traditional or the proxy method.

Traditional Method

Under the traditional method, a retiring allowance may be allowed as "Overhead or other expenditure" that is either "all or substantially all" (ASA) attributable or "directly attributable" to the prosecution of SR&ED in Canada.

For claimants using this method, current expenditures for SR&ED activities include only those expenditures described in subclauses 37(8)(a)(ii)(A)(I) and (II), provided that the expenditure is ASA attributable or directly attributable, as determined by regulation, to the prosecution, or to the provision of premises, facilities or equipment for the prosecution, of SR&ED in Canada. Consequently, to be an allowable SR&ED expenditure, a retiring allowance would have to be either ASA attributable or directly attributable to the prosecution of SR&ED in Canada.

ASA Attributable

The term ASA attributable means 90% or more. Therefore, to be ASA attributable to the prosecution of SR&ED, 90% or more of an expenditure of a current nature must be used for SR&ED.

Directly Attributable

To meet the directly attributable requirements under paragraph 2900(2)(c) of the Income Tax Regulations (the "Regulations"), an expenditure, or a portion thereof, must be directly related to the prosecution of SR&ED and the expenditure would not have been incurred if such prosecution had not occurred (incremental).

In Application Policy SR&ED 2002-01, Expenditures incurred for administrative salaries or wages - "directly related" test, there is a discussion of the meaning of "directly related". For an employee to be directly related to SR&ED, the work performed by particular employee(s) or department(s) must connect with (i.e., "related to"), and be done without an intervening step or intermediary between the employee/department
(i.e., "directly") and,

• the SR&ED work, or
• the SR&ED staff, or
• the machinery/equipment used by staff to perform SR&ED.

Proxy Method

A retiring allowance is not an allowable SR&ED expenditure when a claimant elects to use the proxy method of calculating ITC since overhead is not included in the calculation of allowable SR&ED expenditures under subsection 37(1) and qualified expenditures under subsection 127(9). Instead, the prescribed proxy amount is calculated to represent an approximation of overhead to determine qualified expenditures for ITC purposes only.

Policy

A retiring allowance would be an allowable SR&ED expenditure and a qualified expenditure that is either ASA attributable or directly attributable to the prosecution of SR&ED in Canada if all the following conditions are met:

• it is part of the written employment contract of the employee and the employee becomes a member of the retiring allowance plan;
• it is paid to an employee directly undertaking, supervising, or supporting the prosecution of SR&ED in Canada at the time of retirement or the loss of an office or employment ("hands-on work"); and
• it meets the ASA attributable or directly attributable test (i.e. directly related and incremental), under paragraph 2900(2)(c) of the Regulations.

A retiring allowance paid to an employee carrying out clerical or administrative work would not qualify because the employee is not performing hands-on work.

In determining the allowable SR&ED expenditures and qualified expenditures, the claimant must determine whether or not an amount paid is a retiring allowance or merely remuneration for services rendered during employment.

The current version of IT-337 outlines, among other things, the CRA's policy on what does and does not qualify as a retiring allowance. More specifically, paragraph 13 states that a payment received upon or after retirement or in respect of the loss of employment pursuant to the terms of an employment contract with a former employer is generally viewed as remuneration from the former office or employment. However, in circumstances where the payment can also reasonably be regarded as being in recognition of long service or as compensation for the loss of an office, it is considered to be a retiring allowance. Please refer to the section on "Legislation and Interpretation".

A retiring allowance may or may not be related to services (i.e. the prosecution of SR&ED) and, therefore, depending on its characteristics, a retiring allowance may or may not be an expenditure in respect of SR&ED. For example, when a retiring allowance is a cost, similar to salary, incurred as a result of the terms of an employment contract negotiated when an employee was hired, it is the CRA's view that, the "directly related" test could be satisfied and the retiring allowance, or a portion thereof, could be considered an expenditure directly attributable to the prosecution of SR&ED.

On the other hand, the CRA considers that an amount paid on account of or in lieu of general damages (e.g., damages for the loss of self-respect, humiliation, mental anguish, hurt feelings, etc., or under an order or judgment of a competent tribunal) for something other than in recognition of services (i.e., the prosecution of SR&ED) would not be considered an allowable SR&ED expenditure that is ASA attributable or directly attributable to the prosecution of SR&ED.

An amount paid as a retiring allowance that was negotiated after the employee began employment will not be accepted as an SR&ED expenditure because the retiring allowance was not negotiated to induce the employee to perform SR&ED work (i.e., not directly related to the prosecution of SR&ED).

Finally, a retiring allowance negotiated to entice the employee to retire will not be acceptable as an SR&ED expenditure since it relates to a corporate decision that has nothing to do with the prosecution of SR&ED.

The claimant must allocate all or a portion of the retiring allowance to SR&ED. This allocation should reflect the time spent by the employee in SR&ED versus the overall time the employee was employed by the claimant. Furthermore, the claimant must provide the CRA with supporting information and the rationale used to allocate the retiring allowance to SR&ED.

The CRA should accept the allocation method chosen by the claimant unless it does not result in a reasonable estimate of the SR&ED portion of the expenditure.

Employee specific information to support such an allocation may include:

• total of salary and wages for the duration of employment;
• total of salary and wages, or a portion thereof, allowed as SR&ED for the duration of employment;
• number of years employed; or
• any other relevant and reasonable factors.

Example 1

A large Canadian corporation hired a computer software engineer, Mr. A, in 1995. When he left the company in 2002, he received a retiring allowance totalling $90,000. During this entire time, Mr. A worked exclusively in the prosecution of SR&ED in Canada (hands-on work). The corporation selected the traditional method to file its SR&ED claim. Is the corporation entitled to claim the amount of $90,000 paid to Mr. A as SR&ED?

In this situation, the payment meets two out of the three criteria. However, the CRA has to determine if the retiring allowance was part of Mr. A's employment contract. If so, the $90,000 paid to Mr. A is ASA attributable to the prosecution of SR&ED and is an SR&ED expenditure for both section 37 and subsection 127(9). If not, the $90,000 is a regular business expenditure for the corporation.

Example 2

Mrs. Z is an engineer who started working for B Ltd. on January 1, 1993. As part of her employment package, she negotiated a retiring allowance of $20,000 per year of service. On June 30, 2003, Mrs. Z was laid off as part of the realignment of the company. B Ltd. selected the traditional method and determined that over the years, Mrs. Z devoted 60% of her time working on SR&ED projects while the remaining 40% of her time was related to the general administration of the corporation. The CRA reviewed this claim and concluded that the 60% rate determined by B Ltd. was reasonable. What portion, if any, of the $210,000 retiring allowance paid to Mrs. Z in July 2003 should be included as allowable SR&ED expenditures and qualified expenditures?

In this situation, the three criteria mentioned above are all met. Accordingly, 60% of the $210,000 retiring allowance or $126,000 will be included in the SR&ED expenditure pool under subclause 37(8)(a)(ii)(A)(II) and will also be part of the qualified expenditure for ITC purposes.

Example 3

Same facts as in example 2, except that Mrs. Z only devoted 25% of her time to SR&ED projects during her employment for B Ltd.

In example 3, the first two criteria mentioned above are met. As a result, we have to determine whether or not the retiring allowance paid to Mrs. Z qualifies as "directly attributable" to the prosecution of SR&ED. According to paragraph 2900(2)(c) of the Regulations, a portion of other expenditures, that are directly related to the prosecution of SR&ED and incremental to such prosecution could qualify as an SR&ED expenditure for purposes of determining the amount allowable under subclause 37(8)(a)(ii)(A)(II).

However, since Mrs. Z only devoted 25% of her time to SR&ED during her employment for B Ltd., the CRA concluded that, although a portion of the retiring allowance is directly related to the prosecution of SR&ED, it does not meet the "incremental" test. Based on the facts, the CRA decided that Mrs. Z would have been employed full-time by B Ltd. whether she was involved in SR&ED or not. Consequently, no portion of the retiring allowance would be considered as either an allowable SR&ED expenditure or a qualified expenditure for purposes of the ITC.

Conclusion

In all situations, the claimant has to demonstrate that the amount paid to an employee meets both the definition of retiring allowance and the policy described above. Furthermore, the onus is on the claimant to establish the direct relationship between the prosecution of the SR&ED and expenditures for retiring allowances.

Original signed by
Mel Machado
Manager
Financial Legislative Application Section
SR&ED Directorate